Banks, Bonds, and Accounting Quality

Based on the research of

Based on the research of

When corporations want to borrow, they have two broad options. On the one hand, they can go to the public market by issuing bonds, a practice that totaled about $700 billion in 2005. Or corporations can take the private route and borrow from a bank or similar lending institution. Such loans totaled about $1,500 billion in 2005. Recent work by Jayanthi and Shyam Sunder (Assistant Professors of Accounting Information and Management at the Kellogg School of Management) and Sreedhar Bharath (Assistant Professor of Finance at the Ross School of Business, University of Michigan) breaks new ground by examining how borrowers make this choice. Appearing in The Accounting Review, this work shows how the quality of a borrower’s financial reporting affects not only the choice between private and public debt markets but also the terms of the resulting loan agreements.

“Basically,” said Shyam Sunder, “bond holders charge higher interest, relative to banks, for low accounting quality firms. So those poor accounting quality firms are able to access capital more easily from banks.” The stimulus for this investigation was a course in financial reporting that both Sunders taught at the Kellogg School. “The starting point there was: Why does it matter?” he recalled. “So we started by asking: Does the quality of financial reports matter?”

Their research covered all manufacturing and retail firms that borrowed private and public debt between 1988 and 2003. Their sample contained 12,676 loans obtained by 3,261 firms and 3,681 bonds issued by 709 firms. These data were compiled from databases provided by Loan Pricing Corporation and the Securities Data Corporation. Jayanthi Sunder pointed out a key innovation, saying, “People have tended to look at bank loans separately. In this paper, we jointly model both the choice of market and the borrowing terms.”

Accounting QualityArmed with massive amounts of information on borrowers, bonds, and lenders, the researchers then asked, “What is accounting quality?” Said Shyam Sunder, “Financial reports are essentially matters of estimates. A potential lender wants to know how the firm will perform in the future and how well the financial reports reflect the borrower’s financial health. Accounting quality tries to capture how meaningful and accurate those estimates are in reflecting current performance, and how useful they will be in forecasting future performance.”

The team turned to accrual-based measurements, which are recognized as Generally Accepted Accounting Principles (GAAP), to determine the accounting quality of those firms. “We measure the quality of accruals, modeling the divergence between earnings of the borrower firm and the cash it is generating,” said Jayanthi Sunder. Large deviations between earnings and cash flow, abnormal compared to industry peers, make it harder for debt investors in the bond market to understand and reliably predict the true economic performance of a firm.

The researchers found that borrowers with poorer accounting quality, reflected by larger differences between earnings and cash flow, are more likely to choose private debt such as loans from banks. Compared to public bond holders, banks are better able to gather and process additional information, which can help mitigate potential adverse effects of lending to borrowers with poorer accounting quality. Accounting quality also affects the design of debt contracts. Different borrowing agreements reflect lenders’ differing abilities to process information and renegotiate the contract.

For example, for private debt, accounting quality leads to substantial variation in all contract terms. Firms with poorer accounting quality pay higher interest, face more rapid maturity of loans, and are more likely to have to post collateral. Compared to the best 20 percent of borrowers in terms of accounting quality, the worst 20 percent in the private lending market face interest rates that are 0.14 percent higher, receive loans that mature one month sooner, and are 7.7 percent more likely to have to provide collateral.

Interest Rates Tell the StoryIn the public bond market, however, the higher risk represented by borrowers with poorer accounting quality is reflected only in the interest rate. Firms with poorer accounting quality face significantly higher interest. The top 20 percent of borrowers in terms of accounting quality enjoy interest rates 0.29 percent lower than the worst 20 percent. However, bond maturity and collateral are unaffected.

“We show that different types of lenders respond to accounting quality very differently. If you have poorer quality accounting, it’s harder to borrow in public debt markets since they tend to rely on the reported financial statement,” summarized Jayanthi Sunder. Banks, on the other hand, can use additional, privately communicated information. Potential borrowers are prepared to reveal proprietary information to banks that might help them obtain lower interest for their loans. Banks also have the ability to renegotiate the loan at a later date. Therefore, banks are more willing to lend to firms with lower accounting quality than bond markets.

Added Shyam Sunder, “Banks write richer contracts, where the terms vary on a variety of dimensions—such as maturity and collateral—in response to accounting quality. So banks risk-protect in other ways and hence offer better terms.”

“A borrower can get two things from the paper,” he said, pointing to practical applications for this work. “First, improving a firm’s accounting quality can have significant implications for borrowing costs. Second, given a firm’s level of accounting, executives can see how that should play into the choice of markets and what they should expect as far as contract terms are concerned.”